Why Stocks Will Rise as the
Economy Deteriorates Further

Michael Lombardi explains why stocks will rise as the economy deteriorates further.“Michael, you write about the stock market rising in the weeks ahead and actually ending 2011 higher than it started (see Stock Market: Where it Will End 2011), but on the other hand you often write about the pathetic state of the U.S. economy. How can they differ so much?”

The above is an important question we often receive here at PROFIT CONFIDENTIAL from our readers.

The stock market and the economy…they are two very different phenomena that can often go in the opposite direction in the short term, but that eventually meet in the long term.

Yes, the stock market is a leading indicator of the economy. But in the short term, the job of a bear market and a bull market is to mislead investors as to the real direction of the markets. No bull market goes straight up; no bear market goes straight down. There are peaks and valleys on the way up and on the way down. However, in the long term, the stock market does lead the economy.

Just look at October 2007. The bear market we are presently in started that month. Stocks came down steadily starting in October 2007, but the U.S. economy was doing fine at the time. By the end of 2008 though, the U.S. economy was well entrenched in the worst recession since the Great Depression.

Stock bull markets tend to move in long cycles of about 20 years in duration. A bear market has a shorter cycle, about five to 10 years, as a bear market tends to deal with the excesses of a preceding bull market more quickly. In a nutshell, greed takes a long time to build up. Fear comes quickly.

Let’s move to today, the markets and the economy

If you are a long-time reader, you know my opinion about the stock market. We are in Phase II of secular bear market that will move stocks higher, as investors get the false sense that the economy is doing better and stocks are the place to be again. At this very moment, most stock advisors and investors are still very bearish. Hence, I believe this bear market rally will continue to ride “the wall of worry” higher.

Of all the things the stock market has going for it (strong corporate earnings, lots of pessimism out there), the lack of investment alternatives to the stock market is key. When the yield on the 10-year U.S. Treasury is two percent and the dividend yield on the Dow Jones Industrial Average is 2.5%, stocks are attractive.

But, in the long term, the economy has severe structural problems. I write about them daily here in PROFIT CONFIDENTIAL. The Fed has kept the economy alive the past two to three years by aggressively increasing the money supply. This can’t go on forever.

At some point, the stock market will fall victim to higher interest rates brought about by rapid inflation and Phase III of the bear market will suddenly be upon us. That’s what the 10-year bull market in gold has been all about. At that point, the bear market in stocks and the economy will converge again, just like they did in 2008.

Michael’s Personal Notes:

Yesterday, after the Federal Reserve concluded its regularly scheduled two-day Federal Open Market Committee meeting, Ben Bernanke said the Fed may look at buying more mortgage-backed securities, if the economic situation warranted, loosen up the housing market.

In my humble opinion, the Fed needs to stop forgiving the sins of the past, stop expanding its balance sheet, and start tightening.

Look at the Fed’s actions to date:

— It has kept short-term interest rates down for years and has told us that the Federal Funds Rate will stay near or at zero until mid-2013…short-term interest rates to stay at zero for two more years!

— The Fed has purchased $2.3 trillion in debt, including government treasuries in the period from December 2008 to June 2011 (two rounds of quantitative easing).

— Swapped $400 billion of its short-term securities holdings for long-term debt in order to lower long-term interest rates.

In doing the above, the Fed has significantly increased the money supply. A total of $2.3 trillion has been added to the Fed’s balance sheet. That doesn’t happen without money being created. And the more money created, the less the U.S. dollar buys, the more inflation rises (see Economic Analysis: And Then Came Rapid Inflation), the higher the price of gold bullion goes.

Yesterday, the Fed told us much of what we already know: the economy is growing slower than originally thought; unemployment in the U.S. will remain high; and the European debt crisis is a risk for America.

What the Fed didn’t tell us is that, given its inclination to buy more mortgage-backed securities should the economy weaken further (which it will), another round of quantitative easing is in the cards. In a recent Bloomberg survey of economists, 69% of those surveyed said the Fed will embark on QE3 in 2012.

The government already owns Freddie Mac and Fannie Mae, who jointly own or guarantee half the residential mortgages in the U.S. With the Fed buying more mortgage-backed securities, the government and Fed will get more entrenched in the residential housing mortgage market.

I doubt George Washington ever envisioned a time when the government would own guaranteed loans on homes. This is not what the government was set up to do. It’s this type of Keynesian economics that have gone too far, for too long, and that continue to plunge our country into record debt. It’s also a wonder why gold isn’t trading at $2,000 an ounce today (see Answered: Can I Still Make Money Buying Gold Now?).

Where the Market Stands; Where it’s Headed:

I continue with the belief that we are in bear market rally that started in March 2009. Phase I of the bear market brought stocks down to a 12-year low on March 9, 2009. Phase II of the bear market, which we are presently in, is a rally within the confines of a bear market. This rally could last three to four years. The purpose of this bear market rally is to lure investors back into the “safety of stocks.”

Phase III of the bear market will bring stocks back down to where the bear market originally bottomed; in this case, 6,440 on the Dow Jones Industrial Average. Enjoy the current stock market rally while it lasts!

What He Said:

“Interest rates at a 40-year low: The Fed has made borrowing as easy as possible, resulting in a huge appetite for loans and mortgages. We are nearing a debt crisis.” Michael Lombardi in PROFIT CONFIDENTIAL, April 8, 2004. “We will wish Greenspan never brought rates down so low as to entice so many consumers to have such big mortgages.” Michael Lombardi in PROFIT CONFIDENTIAL, April 27, 2004. Michael first started warning about the negative repercussions of Greenspan’s low-interest-rate policy when the Fed first dropped interest rates to one percent in 2004.